Living in the Promised Land

At a time when the global economy is in sharp decline and the world’s financial system is in disarray, Canada is being cited as a paragon of fiscal and regulatory prudence. More than a decade of balanced federal and provincial budgets, plus domestic banks that remain well capitalized and profitable, are winning flattering mention at home and abroad. Canadians are proud of our status as a global poster child for fiscal and financial performance in an era of pervasive gloom.

Overlooked in the frenzy of accolades and self–congratulations is the quiet but steady evolution of the Canada Pension Plan (and its companion, the Quebec Pension Plan) from a potential economic time bomb into an element of future economic stability. In the last decade our national pension system has been transformed from a liability to an asset. How this happened is a story worth telling. That is what Bruce Little does in Fixing the Future: How Canada’s Usually Fractious Governments Worked Together to Rescue the Canada Pension Plan, and he does it with his long-respected talent for making the complex comprehensible. Little has a knack for enlightening his readers about arcane aspects of the dismal science without talking down to them.

Before exploring how a potential national crisis was averted, one must first understand how it arose.

The original CPP was built on sound principles. Created by an act of Parliament in 1965, it was a major achievement of Prime Minister Lester Pearson. He won not only the support of a minority parliament for the bold initiative, but also the support of provincial governments. From the outset the CPP has been a federal-provincial regime; amending it requires the approval of Parliament and of the governments of two thirds of the provinces with two thirds of the population—a rare federal-provincial check and balance. From the outset it was agreed that Ottawa and the provinces would meet periodically to receive actuarial studies on the soundness of the plan and consider amendments to its benefits and contribution rates.

Initially, the CPP was designed as a plan in which the contributions of current workers paid the pensions of those then retired plus an amount that went into a reserve fund to protect the plan against sudden shocks. When first introduced it was enormously popular. Those who retired ten years after it was instituted received full pensions, even though they had contributed for only a short period. Their return on investment was huge. Working Canadians, many of whom had no employer pensions, were able to look forward with confidence to a portable, partially indexed pension. Politicians of all stripes took pride in having created something that had only a modest cost and enormous public approval. Provincial governments felt like they had won a lottery. The surplus CPP funds were loaned to them for 20 years, not at their own cost of funds, but at the Government of Canada’s borrowing rate. For the provinces, it was a predictable source of subsidized funding.

Everyone was a winner. Or so it appeared. The problem was that the CPP, like any pension plan, is built on assumptions about the future, and assumptions are never more than educated best guesses. Over time, assumptions need to be updated to reflect new information and changed expectations. With infrequent exceptions they are moving parts.

For the CPP, some of the moving parts were changes in benefits introduced by successive governments. Added to the original promises were pensions for widowers (widows were beneficiaries from the outset), child-rearing drop-out provisions, expanded disability pensions and early retirement provisions, as well as full indexation of pension payments. The retirement age was reduced from 69 to 65. Each of these changes was introduced with political fanfare. Unfortunately, while each had a calculable cost, the contribution rates were never increased sufficiently to pay for the new benefits. There were votes to be had with benefit enhancements but only votes to be lost with contribution rate increases.

Societal changes also brought costs to the plan that were not passed on through increases in contribution rates. These included declining birthrates (meaning fewer future contributors to support an increasing number of retirees) and increased life expectancy (meaning more years of pension payments). As well, unforeseen economic developments, especially successive years of high inflation, eroded the strength of the CPP.

During the 1970s and ’80s Canadians, like the citizens of many western countries, rejected the notion of deferring consumption until it could be afforded in favour of spending today and handing the bill to future generations.

As Little explains, it was not that the problem was not understood. Actuaries were calling for action and some provinces, especially Ontario, were concerned. What was missing was the political will to deal with the growing CPP crisis.

A bombshell was dropped in 1995 with the release of the chief actuary’s report. It made clear that for the CPP to remain viable, a dramatic increase in contribution rates would be required within 20 years and the reserve fund would no longer have a surplus with which to buy provincial bonds. Instead it would be redeeming those it already held.

Then finance minister Paul Martin issued a call to arms: “We will have to take steps to ensure that the plan continues to be sustainable. This we shall do … with the provinces.” Thus began a marathon of meetings—meetings among federal and provincial ministers, debates in parliamentary and legislative committees across the country, working sessions with public servants, conferences for experts and public consultations in 18 cities. Underpinning all the dialogue were mountains of actuarial studies, policy analyses and background papers.

Happily, the result was not a classic Canadian compromise but a set of bold and innovative initiatives. First, the contribution rate was increased over a seven-year period from 5.6 percent to 9.9 percent of an individual’s allowable earnings (calculated by taking a person’s income up to a maximum pensionable earnings level—$35,400 in 1996 and $46,300 today—and subtracting a basic exemption of $3,500). No more intergenerational inequity—boomers would start to be charged more appropriately for the pensions they were expecting. Second, no more lending of funds to the provinces at subsidized rates. And third, a new Crown corporation, the CPP Investment Board, was created to invest the growing pool of funds in capital markets. It would be governed by an independent board of directors and staffed by professionals who would operate at arm’s length from government. Its mandate would be unambiguous—to maximize investment returns without undue risk in the long-term best interests of the contributors and beneficiaries. It would be unencumbered by other public policy objectives or responsibilities.

The 9.9 percent contribution rate was selected to produce contribution revenues far in excess of the projected total benefit payments for about 20 years. By the time the cost of benefits exceeded the revenues from contributions, the investment income from the accumulated capital would be more than sufficient to make up the difference. On that basis, the contribution rate would be sustainable and future generations would not have to pay a regularly increasing share of their annual income to provide pensions to their parents and grandparents.

That Canada designed and implemented this model is admired internationally, although many countries with greater challenges continued in denial, paralyzed by the prospect of confronting their own pension problems.

A proof of the genius of the Canadian model is the number of people who take credit for it. Most of them are justified in doing so. It was the result of a collaborative process that involved scores of people—dedicated public servants who understood the file intimately and kept the reform flame alive and politicians from all parties and provinces who formed a collective resolve to do the right thing. The heroes of the story were Canada’s finance minister, Paul Martin, and Alberta’s treasurer, Jim Dinning. They could not have done it alone, but they did lead the way.

How these individuals and governments came together to advance the public good is the story that Little tells. Where one might have expected parochialism or petty one-upmanship, there was active listening and respectful consensus building. Where one might have anticipated procrastination, there was a shared sense of urgency. Where one might have anticipated short-term thinking, the evidence is that the participants focused on long-term durable solutions.

Nonetheless, Canadians are still skeptical. How often does one hear people ask if the CPP will really be there for them when they retire? The answer to this question is an unequivocal yes. But it is the wrong question. What Canadians should be asking is whether the plan will be sustainable in perpetuity with a 9.9 percent contribution rate. The answer to this is a definite maybe.

Enter again those pesky assumptions about the future that seem incapable of sitting still. The reformers of the CPP anticipated the potential problems these ever-moving parts might cause and addressed them in two sensible ways. First, the chief actuary for Canada is required to assess the condition of the CPP, including the sustainability of the contribution rate, every three years, or sooner if Parliament changes the provisions of the plan. His report becomes a public document. This transparency eliminates the risk of another bombshell. Second, the reformers introduced a default provision whereby the contribution rate is automatically increased on a formula basis if the ministers of the day fail to act in a timely manner to redress any shortfall. Canada is the only country in the world with such a fail-safe mechanism.

Since the CPP was reformed, the chief actuary has completed three studies that have been released to the public. Each study has concluded that the 9.9 percent contribution rate was sustainable for 75 years and beyond. However, in his 2006 study the chief actuary ran two adverse-case scenarios—one based on negative investment returns and the other on serious underperformance of the Canadian economy. If either scenario materialized, it would lead to the need for an increase in the contribution rate. Given the recent performance of markets and the outlook for global economies, many Canadians will be on the edge of their seats as they await the 2009 study.

No one should be overly worried. Any required change to the contribution rate would be modest and the CPP pension itself would remain secure. Canadians can sleep soundly knowing that their indexed CPP cheques will arrive each month for the rest of their lives.

Other components of individual Canadians’ retirement income are not as certain. Defined benefit pension plans are wrestling with the consequences of funding deficits and plan sponsors are rethinking their commitments to guaranteed pensions. Defined contribution plan participants are trying to decide what to do in the face of relentlessly volatile markets, as are most holders of tax-sheltered registered savings plans, whether self-administered or managed by professionals.

While there have been few places to hide from value erosion, the situation is not as glum as it sounds.

In terms of aggregate retirement assets in government plans, employer plans and personal plans, Canadians live in a promised land. According to a Statistics Canada study, as of year-end 2007, Canadian pension assets equalled 138 percent of gross domestic product. A comparable study by the Organisation for Economic Co-operation and Development and the World Bank identifies Canada as one of only seven countries in the world where retirement assets exceed 100 percent.

This should be comforting news for those who wonder if they will be able to retire with dignity. It is especially good news for Canada. Why? Because a retiree population with a predictable and secure source of monthly income is a great economic stabilizer. It represents reliable future consumer spending, which is the life blood of developed economies. A large portion of the Canadian population will be able to live on its own resources without requiring the largesse of the state.

It also means that governments will have greater capacity to spend on items at the top of our collective wish list, such as health care, education and environmental protection. And it means that a large pool of capital will exist for investment in long-term assets that will help fund economic development at home and abroad.

The reforms of the Canada Pension Plan that Bruce Little so ably chronicles are an element of the pension fund bedrock on which a strong economic future for Canada can be built.